Merger Madness

Not since the days when Liddy "I never saw an airline merger I didn't like" Dole headed up the U.S. Department of Transportation have there been so many carriers proposing to get together in so many unnatural ways. This time around, the result could conceivably be a U.S. market dominated by only three huge air carriers. One can imagine what would happen to the holy grail of airline competition. AVweb's Ken Cubbin did sit down to imagine what the world could look like if these proposed mergers are approved. Here's his take on what the U.S. Departments of Transportation and Justice should consider before allowing these mergers to go through.

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About the Author ...

Ken Cubbin is a
flight engineer for "a major international airline," presently based
in North Carolina. He is an Australian who began his career with Qantas more
than 25 years ago. When not performing cockpit duties for "a major
international airline," Ken pursues a second career as a writer, devotes
time to his wife and four-year-old son, and studies for his MBA degree.

If the Justice Department does not step in and halt the
process, the U.S. domestic airline industry may soon be dominated by three
mega-carriers. United may purchase US Airways, American may join forces with
TWA and/or Northwest and Delta may absorb Continental or America West — at
least that's the way things stood earlier this year. Perhaps next week
Northwest may buy Continental and Delta may buy Alaska Airlines; who knows? To
complicate matters, American has offered to buy a significant portion of US
Airways and Northwest has been ordered by the Justice Department to divest its
part-ownership of Continental.

Abbott and Costello Rule

Who's on first? What's on second?

Get my drift? The status quo keeps changing daily and it's darn-near
impossible to keep up with who's buying whom. But it seems inevitable that
there will be consolidation of the major airlines from which three
mega-airlines will emerge. If the mergers are approved by the Departments of
Transportation (DOT) and Justice, consumers and politicians are concerned that
ticket prices may significantly rise. Are these concerns warranted? Not
necessarily. At least not if the DOT and Justice follow my advice and apply
stringent conditions before granting approval.

Putting aside for the moment the emerging reluctance on Capitol Hill to
approve these mergers without the carriers making meaningful progress toward
minimizing delays and improving customer service, I decided to use the
principle of supply and demand to analyze the likelihood of rampant ticket
price increases if we are left with three mega-airlines. Keep in mind that I'm
a student and not a professor of economics, and that this analysis is relative
to conditions I have set before the mergers receive DOT and Justice Department
approval. In this case, I am the supreme arbitrator in when, how, and in what
form airline mergers will be permitted to proceed.

Setting The Stage

As a condition of approving the proposed airline
mergers, the DOT and Justice Department must demand that the newly formed
mega-airlines divest a significant percentage of their gates at hub airports
in order to facilitate niche airline competition. They must also ensure that
major airlines cannot hold more than 25 percent of niche airline stock,
otherwise 'puppet' competitors might be set up to regain lost slots at hubs.

Congress must forgo the impetus to re-regulate airlines despite the ranting
of some self-interested politicians; however, the Justice Department must
ensure that airlines do not engage in predatory pricing practices. Since
predatory pricing allegations are extremely difficult to prove, the DOT will
need to limit how a major airline responds to a niche airline competitor in
the future. Now I know this is contradictory to my claim that there should be
no re-regulation of the airlines, but this point is critical to maintaining
niche market competition. Although the very nature of a free market means that
competitors must be able to respond as they see fit, in this case, major
airlines should be limited to matching niche market competitors fares and
seats available. For example, a major airline would not be permitted to offer
twice the number of flights at its niche competitor's price.

It's The Economy, Stupid...

Significant factors, such as threats of re-regulation, labor disputes,
airline failures and increased fuel costs will affect the supply of airline
seats in the near future. Economic indicators suggest strongly that the U.S.
economy is significantly slowing and this will result in a reduction in demand
for airline travel. Although the Fed has already reduced interest rates, the
lag effect will mean that the economy will slow a little further before
picking up by the end of this year — at least, that's the popular opinion.

The U.S. economy, under the steerage of the Federal Reserve, should recover
and grow at an average of 3 percent from 2003 to 2005. Given the Justice
Department's new criteria for predatory pricing protection, new entrants will
enter the market and mega-airlines will be unable to monopolize heavy-demand
routes. As the economy picks up, demand may outstrip supply for a short period
as it takes longer to add seats to the market than it does to subtract them.
This will result in marginal price increases from 2003 to 2004. However,
subject to oil prices stabilizing at reasonable levels in the medium term (a
wild card), labor cost containment and stability in the global foreign
exchange markets, supply should increase to match demand by the end of 2003.

Given the set of circumstances I have outlined, ticket prices will probably
not increase in the two years after merger approvals other than for fuel price
and labor price increases. In fact, United has vowed not to increase prices
for two years in order to increase its chances of gaining regulatory
authorities' approval. However, after that time, marginal ticket price
increases will probably occur. The size of that increase will largely depend
on how many new niche airline competitors have entered the market. But if the
conditions I have outlined for the Justice Department and DOT to approve the
mergers are set, new entrants to the market is assured.

Sound too good to be true? Let's see if I can convince you.

What Brought Us To This Present Situation?

The U.S. airline industry was transformed under The Airline Deregulation
Act of 1978. Almost immediately, as can be seen from Table 1, a flurry of
merger activity took place as airlines struggled to consolidate and expand
their route structures.

Merger opponents declared that competition was at an end, that fares would
skyrocket and service plummet as a result of deregulation. History, however,
proved the pundits wrong. Ticket prices, as measured in inflation-adjusted
constant 1982 dollars, have actually decreased by approximately 40
percent.

2. UAL's extensive east-west system will fit nicely with USA's
north-south system creating the first truly efficient nationwide
network.

3. USA's hubs in
Charlotte, Philadelphia and Pittsburgh will add potential domestic and
international route expansion.

4. Assets will be divested in Washington DC and other markets to
satisfy the Justice Department and to ensure future competition from
regional operators.

5. Frequent flyer
programs will be consolidated offering passengers more destinations than
any other airline program.

6. Travel agents are guaranteed no reduction in domestic standard
base commission rates for two years following close of
merger.

7. No increases
to domestic fare structure for two years following close of merger,
except for increases in fuel costs and CPI.

Table 2:
Passenger Benefits Gained by UAL and USA
Merger

After deregulation, on the supply side, new low-cost entrants entered the
market, energy costs declined, labor costs were contained and more fuel
efficient aircraft were brought into service.

Because aviation infrastructure has remained under government control,
expansion of airports and air traffic control systems have not matched the
rapid expansion of air travel. As a result, today's aviation infrastructure is
strained to capacity and passenger complaints over lengthy delays and airline
service have skyrocketed. For example, the DOT recently reported that 9,606
complaints about airline service were lodged in 1998; this reflects a 25
percent increase over the year before.

... Congress Reacts ...

With the passage of AIR-21, a bill signed by President Clinton in 2000 that
will allocate funds to improve aviation infrastructure, improvement and
expansion of aviation facilities are underway. However, airlines state that
the system is strained to capacity now and the only way for them to increase
efficiency in the near term is to merge. For example, UAL has issued a
statement reflecting how passengers will be benefited by its merger with US
Airways. These points are summarized in Table 2.

On the other hand, politicians and consumers are concerned that the current
domestic market share of airlines as depicted in Figure 1 will be
transformed into an oligopoly situation where the three proposed mergers (not
yet determined) will dominate 81 percent of the domestic market. See Figure 2.

Congress voted to allow the airlines
time to voluntarily address passenger service problems and airlines responded
by introducing a series of commitments to their passengers (See Table 3.)
Unfortunately, passenger complaints are still forthcoming and Congress is once
again threatening legislation — it seems that it's just a matter of time
before some legislation is enacted.

...Oligopoly Attributes...

An oligopoly is said to exist when a handful of firms produce most of the
output in an industry. Economically speaking, the U.S. domestic airline market
is in the mature stage of development, and as pointed out by Edward Mansfield,
a noted economist, "Since firms cannot maintain growth rates to which they are
accustomed merely by protecting market share, there is often a tendency for
firms to attack the market shares of their own rivals." Some senators have
expressed concerns that a spate of mergers in the airline industry could leave
passengers facing higher prices and reduced service. Those concerns are best
summed up by a statement by Senator John McCain, "I cannot think of any
marketplace that works better for consumers with fewer
competitors."

Rule on unfair and deceptive practices would apply if airline
tells passenger fare is lowest when it isn't.

Refunds

Try to make credit card refunds in 7 days.

If
refund takes more than 20 days, it is an unfair
practice.

Stranding Pax Overnight

Spell out and publicize policy on assisting passengers under
these circumstances.

N/A

Lost Bags

Make every reasonable effort to return mis-routed checked bags
in 24 hours.

N/A

Delay Information

Fliers will promptly be told about delays, cancellations and
diversions.

Airlines cannot lie about the reason for cancellation, but no
further comments or threats made on this issue.

Ground Delays

Make every reasonable effort to give food, water, restroom
access and medical treatment to passengers on the ground for long
periods.

Not covered in report.

Table 3:
Airlines' Voluntary Promises to Passengers (December
1999)

... Labor Unions ...

Historically, most airline mergers were achieved at a high cost of the
acquiring airline, largely because of difficulty in melding two labor forces.
For example, when US Airways acquired PSA in 1987, US Airways went from having
one of the highest profit margins in the industry to the least profitable.
This was largely due to large differences in pay scales and working conditions
between the two airlines.

Airlines can hardly satisfy the demands of their current employees,
therefore, it will be extremely difficult to meld two dissatisfied workforces.
Labor problems have the effect of shifting the airline's supply curve to the
left.

... Fuel Costs ...

Labor and fuel are major costs for airlines (Figure 3). Major
airlines have the ability to hedge against fluctuations in fuel prices,
however, some are more successful than others. Recently, airlines have
increased ticket prices due to fuel costs which have virtually doubled since
last year.

... Political Threats ...

Assistant U.S. Attorney Joel Klein, head of the Justice Department's
antitrust division, has stated that the hub and spoke system that developed
after deregulation has driven out competition in many communities. He also
added that predatory pricing by the big airlines has been practiced to keep
low-cost carriers out of their hubs. In my mind, there is no doubt that Mr.
Klein is correct; that is why it is critical that niche airline competition be
protected in the future if we are left with three mega-carriers.

In the House of Representatives, an armada of bills that would give fliers
information about fares, flight cancellations, frequent-flyer awards and other
benefits are in various stages of debate. However, given that the Republican
party now dominates Congress, it seems unlikely that any significant
re-regulation will occur in the next two years. Airlines will still be
pressured into improving customer service, but I can't see a significant shift
in supply occurring due to political interference in the short term.

There is a strong link between GDP growth and travel growth. According to
Boeing, this is due to growth in the workforce and by increases in
productivity and investment. GDP growth in North America will be lower than
projected growth in developing nations. Recently a slowdown in the domestic
economy has been suggested as imminent by indicators, such as The
Manufacturing Activity Index, Index of Leading Economic Indicators, housing
starts decline, a fall in auto sales, a rise in unemployment and a drop in
consumer confidence.

As airlines have been purchasing new aircraft in the nineties, a severe
slowdown could result in over-capacity and a need for airlines to reduce
prices to maintain cash flow. If this were to occur, a price war could break
out and a kinked demand curve for each airline would be evident. Basically,
this just means that airlines will be stuck between a rock and a hard place -
not able to increase ticket prices, and getting little benefit from decreasing
ticket prices.

Figure 3,
Airline Cost Index For The First Quarter Of 2000(Click image for larger
version)

However, under the leadership of Alan Greenspan, the Federal Reserve has
been focused on maintaining economic growth in the region of 3 percent.
Recently the Fed reduced interest rates by one-half percent after having
already reduced rates by the same amount in early January. This should produce
an increase in money supply that will give the economy the boost it needs
without threatening to increase inflation.

President Bush has also indicated that he will urge Congress to pass a
tax-reduction package that should stimulate consumption. Further, the airlines
have developed more sophisticated models that now allow them to better predict
demand fluctuations. With reference to Figure 4, note that
the difference in airline seating supply — available seat miles (ASM) — was
far more volatile and out of synch with demand — revenue passenger miles
(RPM) — in the 1980s to 1992. However, from that period to the present,
supply and demand have been relatively stable. This indicates that airlines
were more prudent when it came to adding supply of seats choosing instead to
realize better load factors. For the next five years, I am predicting a
virtual match of supply and demand of seats.

One factor in the economy that many economists are not talking about, is
the enormous increase in the wholesale cost of natural gas. Since many
electrical power facilities use natural gas as a fuel, electrical power costs
will also increase. This will not only impact consumers directly in the form
of increased monthly expenses (reducing disposable dollars for consumption)
but will significantly increase manufacturing costs. In other words, things
might get a whole lot worse before they get better. Let's hope not, but you
can bet that Alan Greenspan is not reducing interest rates lickety-split for
nothing. He is hoping that the stimulus of lower interest rates will
counteract the drop in consumption that is bound to occur for the reasons
outlined above.

Conclusion

Despite the slowdown in the U.S. economy, the probability of several
low-cost airline failures in the near term will mean capacity will fall to
match reduced demand. In the short run, consumers may reduce their
discretionary travel, and business travel may also decrease as a function of
the economic slowdown. However, since it is inherently more problematic to add
aircraft seats to the market (purchase new aircraft) than it is to remove them
(park aircraft), there is bound to be a period where demand outstrips supply.
This period should last less than one year.

UAL has pledged not to increase prices for two years after their merger
with US Airways, other than for fuel costs and consumer price index, and other
airline mergers are going to have to reciprocate if they hope to gain
approval. There is a possibility that this promise could cause latent upward
pressure on prices, particularly if labor problems at the mega-airlines
significantly increase costs.

Another wild card in the national economic outlook is the energy crisis in
California. Since California has such a significant impact on the nation's
economy, unless some solution to its power shortages can be resolved quickly,
its manufacturing base will undoubtedly realize higher marginal costs. As I
pointed out before, the nation's economy could decline severely before it
recovers; however, as a nation, history shows that we are incredibly
resourceful. Therefore, I am optimistic that answers will be found for these
problems.

The newly-formed mega-airlines might initially
find it difficult to meld two labor forces; however, ultimately they should
enjoy lower marginal costs due to increased economies of scale, and this
should be reflected in stability in ticket prices. Labor problems tend to be
easier to resolve in an economic slowdown when employees are fearful at losing
their job.

I think it's critical to the future of the airline industry that the DOT
and Justice Department set the stage to ensure niche market competition exists
after merger approval. Prices on some routes will be way out of proportion
with less competitive routes; that is the situation now and that will be the
situation in the future. But if they are assured access to hub airports, any
number of niche market competitors will jump at the chance to take a slice of
pie away from the big boys. Just look at how successful Southwest Airlines has
been at this strategy — albeit mainly through secondary airports. Therefore,
providing the DOT and Justice Department limit mega-airline reaction to
matching prices and seating capacity, predatory pricing tactics will not
occur.

Is this limiting free market competition? Absolutely.

Most industries are regulated in various forms anyway, so having to pull
the reigns in on the airlines is not unusual.But if conditions for mergers
are not set, what is the alternative?

The answer is, three airlines doing what the hell they please, raising the
ire of politicians and raising the specter of full re-regulation.

Service quality has always been proportional to ticket prices, so don't
expect to get any improvement in service, with or without the mergers going
ahead. The bottom line is, if you want a cheap ticket, don't whine about the
legroom.

If the DOT and Justice Department do not take the initiative and insist on
divestiture of slots at hub airports before they approve the mergers all bets
are off. Pundits who predict an increase in ticket prices coupled with a
reduction in service will probably be proved correct. As an analogy, think of
the quality of automobile that was forced upon us when there was such limited
competition among car manufacturers in this country. Remember when a radio was
an optional extra?

Of course, there are other ways to ensure competition continues, such as
granting foreign airlines the right to carry passengers on U.S. domestic
routes. After all, foreign competition was the way we finally got value for
money in the automobile industry. Realistically, however, that is unlikely to
happen unless other countries reciprocate. Therefore, the need to maintain
competition among the airlines must be addressed domestically.

One final point: For those who think that the
airline mergers should be categorically disapproved, think about what would
happen if the mergers did not go ahead and some of the major airlines now in
service went bust. For example, what if TWA stopped operating, who would pick
up the routes?

Right — so what's the difference? We would still be left with fewer
airlines.

But, if airlines are permitted to fail in lieu of being taken over by a
willing partner, thousands of jobs might be permanently lost. You think you've
got a labor problem now, just wait until the airline you work for goes
belly-up.

Question of the Week

Picture of the Week

As aviation photos go, this was the best this week but there are some great beauty shots when you click through. In the meantime, congratulations to Daniel Gillette for this very nice photo he calls Sunset Pitch-Out. The photo is copyrighted by Gillette.